Live By The Sword, Die By The Sword
The Orlando Sentinel reported that the Walt Disney Company retirement plan committee is facing a class-action lawsuit for offering the Sequoia Fund in its portfolio of investment choices for employees. Why? Because Sequoia lost 7.3% last year and is down over 13% this year, mostly due to one bad investment: Valeant Pharmaceuticals. Over the last year or so that company was involved in a controversy about drug price hikes and the use of a specialty pharmacy for the distribution of its specialty drugs, and is the subject of some regulatory investigations. As a result its stock price had plummeted by about 90%, dragging down Sequoia’s performance in an otherwise positive year (so far) for the markets. The suit alleges that the committee should have known that Sequoia was an imprudent investment because of its concentration in only 35 different companies and especially in Valeant.
I’m sure this is just one of many lawsuits targeting not only retirement plans that offer the fund but also Sequoia directly. Yet based on the fund’s past history it’s safe to say no one would ever have predicted this. The Sequoia Fund was founded in 1970 by Richard Cunniff and Bill Ruane, who was a friend of Warren Buffett and a co-disciple of legendary value investor Ben Graham. The fund initially invested a large portion of its assets in Buffett’s Berkshire Hathaway company, and Buffett himself publicly recommended the fund at its opening. For the next forty years the Sequoia Fund went on to return 14% annually on average, as compared to only 11% for the S&P 500. In 2010 the fund managers diversified away from Berkshire, and that action resulted in a 13% return in 2011, better than 99% of all U.S. value stock funds. For decades Sequoia Fund’s performance had been better than 90% of its peers, and until last year it was considered one of the best and safest actively-managed value-oriented U.S. stock mutual funds in the country.
Then came 2015. Management made a mistake, both in their original purchase of Valeant as well as in hanging on to the shares for too long as the company’s problems escalated. And now, as a result, participants in Disney’s retirement plan consider the Sequoia Fund to have been an imprudent investment choice.
I looked up the word in Webster and it means lacking in discretion, wisdom, or good judgment. So the lawsuit’s implication is that the Disney investment committee should have had the wisdom or good judgment to know that the Sequoia Fund, with a concentrated position in just a few stocks, was bound to perform poorly if there was a problem with any of the fund’s holdings.
But isn’t that exactly how any actively-managed fund works? An actively-managed U.S. value stock fund, for example, must by definition be holding some subset of all possible U.S. value stocks, which means it would always be more concentrated than an index or broad-coverage fund in that asset class. So aren’t the plaintiffs in effect arguing that an actively-managed mutual fund is an imprudent investment?
Not necessarily, they might say. It was the egregious degree of concentration in Valeant that was the problem with Sequoia. But for decades the fund had a higher percentage invested in Berkshire than it ever did in Valeant. Why weren’t there any complaints back then? Obviously because Berkshire consistently performed well (or at least didn’t have any catastrophic failures), and the fund’s shareholders made lots of money.
There are a couple of important lessons from this situation. First, if you run an actively-managed mutual fund, you are by implication promising that you will outperform other funds in your asset class. Otherwise there would be no reason for anyone to invest in your fund rather than in some cheaper index or broad-coverage fund. That means you are going to be held accountable by investors any time your fund loses money (or even just underperforms relative to your peers). In other words, if you promise outperformance, you have to deliver outperformance. Not just once but year after year after year. Live by the sword, die by the sword.
For investors, it should be clear that any actively-managed fund that purports to (or actually does) beat its asset class for any period of time, such as Sequoia, has to be doing it by concentrating on a subset of that asset class, which means by definition taking on more risk. Higher returns can only be achieved through higher risk. And that means bigger losses when they occur. And they will occur at some point, because by concentrating on a subset of the market, fund management is attempting to predict the future (i.e. these stocks will do better that the overall market). In Sequoia’s case the risk had always been there, but for many years the fund was fortunate enough to have invested in a handful of companies that did well. No matter. When things turned sour, investors lost money, and the lawsuits started to fly.
The alternative is to avoid funds that promise higher returns and instead invest in funds that provide market returns or slightly better through better cost and/or risk control. They are out there.